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June 20, 2005

The New Exchange Business

By Jamie Selway

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  • The New Exchange Business

Ten years ago, the notion of a for-profit stock exchange was unthinkable. But since then, the invisible hand has pushed the exchange business model from country club to corporate, culminating in the announced NYSE-Archipelago and Nasdaq-Inet mergers. The effect on the marketplace will be profound and positive. Historically, exchanges were organized as not-for-profit clubs that offered proximity

to a trading community via a seat or trading permit. Telecommunications and technology devalued proximity. Indeed, by the late 1990s, a group of broker-sponsored, for-profit marketplaces-known as ECNs and ATSs-posed an increasing challenge to legacy exchanges. With technology came a fundamental change in business model. The new marketplaces were run like businesses and responded to client, not member, demands. While derivative marketplaces adopted this for-profit, electronic approach-think Chicago Mercantile Exchange for futures and International Securities Exchange for options-questions remained on the equities side. Did NYSE and Nasdaq "get it?"

The marketplace got an answer to that question in technicolor during the week of April 19. First, the NYSE announced a reverse merger with Archipelago. In a single stroke, the NYSE would become a for-profit, publicly-traded enterprise with a battle-tested electronic platform and a sizeable Nasdaq business. Two days later, Nasdaq emerged as victor in the auction for Instinet's Inet matching engine, thereby capturing market share and arguably the best matching engine technology around.

Both transactions still have many rivers to cross, and some important details aren't yet clear. But a two-man race between NYSE and Nasdaq is clearly taking form. Below are five thoughts about the brave new world.

1) Fragmentation Goes, Competition Stays. The deals produce two large liquidity pools. That is a reduction in the market fragmentation and complexity. Adding market shares, the new NYSE will have roughly 85% of listed trading and 20% of OTC. Conversely, the new Nasdaq will have about 15% of listed and 80% of OTC names, including the 25% of the tape that is internalized. As NYSE goes electronic-and looks more like Nasdaq-order flow will become more fungible. As Nasdaq pursues its "price leadership" strategy (read: free trading), it's in a better position to gain market share than the NYSE. But more importantly, the marketplace abhors a monopoly. Both exchanges will be viable simply because they serve to counterbalance the other.

2) New Frontiers. New NYSE and Nasdaq will have at least three fronts on which to expand. The multi-product golden fleece has received substantial press coverage. Still, this idea of trading options, fixed income and foreign equities may be more sizzle than steak. A for-profit approach to equities clearing, which could replace the mutually-owned DTCC with an exchange-owned and -operated clearing house along the lines of the CME, is an interesting opportunity. But perhaps the most fertile frontier is the creation of new order types and execution methods. Some broker-provided tools, such as low-grade trading algorithms, are sufficiently commoditized to warrant a role for exchanges. (Isn't the NYSE's CAP order essentially a VWAP algo?). Expect a tension between these large for-profit exchanges and broker-dealers, not unlike the tension between ECNs and Nasdaq dealers in the late 1990s.